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Ally Financial bets on risky subprime car loans

NEW YORK (Reuters) - Ally Financial Inc, the United States' largest maker of car loans, hopes that people have forgotten the time when "subprime" became a synonym for "disaster."

Ally, once known as GMAC Financial Services, is getting ready to go public this year, and is making the case that subprime loans for used car buyers are not about to produce the same results that they did in the housing market a few years ago -- a near-collapse of the financial system.

Auto loans performed relatively well during the downturn, and demand for cars is up, so auto lending is one of the few types of consumer debt that is growing.

Ally wants to show investors that this makes it different from many other banks, which are struggling with weak loan demand and their own soured mortgages.

The company is making more loans to subprime borrowers, and financing more purchases of used cars, both steps with higher risk. It has said it wants to raise the percentage of auto loans on used cars that it makes to 50 percent from its current 20 percent.

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Subprime car lending is "a very attractive business today," Ally President William Muir told analysts on May 3. Profit margins on the loans more than cover the cost of expected losses from borrowers who fail to repay, he said. Plus, providing loans on used cars endears the company to dealers.

That may sound like a great plan now, but similar arguments about subprime mortgages were common in 2003, analysts said.

And, Ally and its competitors may follow the pattern of past credit cycles, where lenders make increasingly risky loans at lower interest rates until waves of defaults and losses swamp them. Loans that seem safe can sour quickly.

Some banks, including JPMorgan <JPM.N>, are already tapping the brakes on auto loans because profit margins have become too slim given the risk.

Ally needs to stretch. Its funding costs are several percentage points higher than most of its banking rivals, which puts it at a disadvantage. Ally also uses a lot of money from the fickle credit markets. And General Motors <GM.N> is making more of its own loans, which could make Ally's future revenue less dependable than it is now.

Ally is the kind of company that "will likely need to call for the government's financial ambulance at some point in the future," said James Ellman, a hedge fund portfolio manager at Seacliff Capital in San Francisco. "I don't know if it is sooner, or later, but it will happen."

In a written comment for this story, company spokesman James Olecki said, "Ally Financial's strategy is to extend credit using sound underwriting criteria and responsible financing practices."

"We accept retail auto contracts through the full credit spectrum -- including nonprime -- as a normal part of our business," he said. "We place greater emphasis on the higher end of the nonprime spectrum and we only approve credit for qualified customers who demonstrate the ability to pay."

TOUGH COMPETITION

The government's ambulance came for Ally three times during the financial crisis as Ally's book of subprime mortgages collapsed. Taxpayers injected more than $17 billion into the company, which had assets of $287 billion in 2006 before loan values collapsed.

Those bailouts left the government holding a 74 percent stake in Ally, which the Treasury plans to sell, starting with the company's initial public offering. The deal could seek about $5 billion from investors in what may be the biggest IPO by a U.S. lender in more than a decade, according to Renaissance Capital, an investment advisory firm.

Ally filed its initial prospectus with regulators in March, and stock sales often come within three months of such a filing.

Public companies face much more pressure to boost profits, which is where things could get tough for Ally.

"If Ally wants to achieve the kind of growth shareholders will be looking for, it has to look beyond the business of prime loans," said Gimme Credit analyst Kathleen Shanley. "This segment of the market is extremely competitive; hence the company's increased focus on used cars and nonprime buyers."

To many analysts, those steps make sense. Used car rates can be several percentage points higher than new car rates. Subprime lending adds more. Loans on used cars to borrowers with subprime credit scores paid lenders more than 9 percent, compared with 5 percent or less for used car buyers with solid credit, according to data from credit bureau Experian.

"The risk-adjusted returns in the used car market look very favorable," said Credit Sights analyst Adam Steer.

Used car buyers taking out loans tend to be less credit-worthy than new car buyers. Borrowers buying used cars in the first quarter had average credit scores of 663, compared with scores 766 for new car buyers, according to Experian.

That may seem worrisome, but subprime auto lending is not as risky as subprime mortgage lending, said Steer. Car loan payments are smaller and more manageable for borrowers than mortgage payments, he said. Plus, the money is scheduled to be repaid faster, and the loan collateral, the cars, is more easily seized and resold than are houses.

The average used car loan in the first quarter was made for $16,636 and required monthly payments of $343 for 58 months, according to Experian.

"A lot of consumers chose to default on their mortgage, but remain current on their car loan," said Kirk Ludtke, an analyst at CRT Capital LLC in Stamford, Connecticut.

Default rates for auto loans were relatively low from May 2007 through October 2010, according to David Blitzer, managing director at Standard & Poor's. The peak rate for auto loan defaults was 2.75 percent in February 2009, which was less than half of the peak rate experienced by first mortgages and less than a third of the rate seen in bank-issued credit cards.

The lower default rates make car loans attractive for other lenders, not just Ally. Banks including TD Bank Group, which bought Chrysler Financial in December, and Spanish banking giant Santander <SAN.MC>, which bought auto finance units from Citigroup <C.N> and HSBC <HSBA.L>, are piling into the market and squeezing profit margins as they offer borrowers more choices.

Banks, particularly large ones, eased credit standards for new and used car loans in the first three months of this year, the Federal Reserve found in an April survey of lending officers. The banks also tended to trim the amount they charged for the money over their own costs of funds.

JPMorgan reduced its new auto loans by 24 percent to $4.8 billion in the first quarter from a year ago.

Ally, in contrast, said it lent $11.6 billion in the same quarter in the United States, up 93 percent from a year ago. The company made nearly 10 percent of all U.S. auto loans, according to Experian. It boosted used car volume in the first quarter by 128 percent compared with a year earlier.

All told, Ally has $56 billion of consumer car loans on its books, nearly three times its $20 billion net worth.

HIGHER FUNDING COSTS

Ally has a particular disadvantage as lenders' profit margins get squeezed: it paid an average of 5.16 percent of interest, annualized, on its liabilities in the first quarter, more than five times what JPMorgan Chase and Wells Fargo & Co <WFC.N>, the second-biggest auto lender, paid.

Much of the extra cost comes because Ally relies so heavily on borrowing in the bond markets, which is more expensive than using depositors' money.

The company is advertising for more deposits, but because it does not have a branch network, it must pay higher rates than well established banks to attract customers. Ally paid an average 1.83 percent for deposits in the first quarter, while JPMorgan Chase paid 0.53 percent and Wells paid 0.38 percent, according to company filings for the first quarter.

Sources have said that Ally may try to buy ING Direct, which will give it more deposits, but not necessarily ones as cheap as those of big banks.

Ally also may lose an important advantage: its connection with GM. Its former parent was the source of half its car loans in the last quarter. But last year GM bought AmeriCredit to be its new in-house financier for dealer inventories and customer purchases.

Special loan marketing deals Ally has with GM and Chrysler are scheduled to expire in 2013.

Ally's emphasis on used car loans comes as subprime borrowers account for a larger share of the business. Industry-wide, some 40 percent of used car loans were made to the lower ranks of subprime borrowers in the first quarter, up 8 percent from a year earlier, according to data from Experian.

The lending and buying has helped drive used car prices up. They are at all-time highs, according to Manheim Consulting, an automative consultancy.

The danger with record prices, said CRT Capital's Ludtke, is "there's only one place to go and that's down." Declines in used car prices could translate to higher losses when borrowers default.

Auto lenders, including Ally, are being more careful than they were before the recession, said Bob Ghent, owner of Ghent Chevrolet and Cadillac in Greeley, Colorado.

For example, when Ghent's dealership refers customers to lenders, Ally and its competitors routinely call borrowers and their employers and talk to them directly. The banks are also lending less compared with the value of the cars.

"They are being smarter," says Ghent.

But he makes no predictions how long the prudence will last: "When they want business, they will lower their standards. That's just competition."